Thursday, 21 February 2019

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Regulatory change means a never-ending process of recapitalisation for banks. Treasurers are grappling with a new wave of acronyms and gorging on CoCo debt but without quite knowing the rules of engagement.

“I’m here to tell you something my friend, you can eat and eat and eat, but nothing will ever fill that void.” So declared Brad Pitt on the perils of over-eating in his cameo as fat-buster Will in Friends – but the message may also ring true for bank execs and treasurers around the world.

Since the near-catastrophic events of 2008 when the world teetered on the brink, banks have been forced to pile on the capital, hoping it would assuage regulators, only to be faced with another round of regulations.

Some rules were dedicated to protecting entire economies from the failure of oversized lenders. Others merely imposed new layers of transparency, illuminating a once opaque industry but trimming profits at hard-up financial institutions. Either way, whatever new legislation was heaped upon their staggering frames, it was never quite enough.

Enter TLAC

The Basel-based Financial Stability Board’s new rules, first unveiled in November 2014 at the meeting of the G20 group of nations in Brisbane, propose a minimum total loss-absorbing capacity on 27 global systemically important banks, or G-Sibs.

Each of the tagged institutions (for now the list excludes China’s largest banks), from Wells Fargo to HSBC and Mizuho to Credit Suisse, will need to hold more equity and convertible debt, the better to absorb losses in the event of future crises.

The FSB’s message was clear: no bank deemed too big to fail would ever again be bailed out by the taxpayer; during future crises, the buck would have to stop at the front door of the bank’s HQ.

TLAC remains a work in progress, despite the emergence of a more complete set of laws in February. It offers lenders and the wider financial industry only “a tentative set of rules”, said Jonathan Weinberger, head of capital markets engineering at Societe Generale.

“We’re still waiting for more specificity to emerge. For now, the way to think of TLAC is that it is designed specifically to insulate taxpayers from the consequence of future bank failures. That is how it primarily differs from other new post-crisis bank regulations.”

Banks, almost certainly, will be forced into (yet another) round of capital raising, notably in the form of Additional Tier 1 and Tier 2 debt. Lenders will also likely have to increase their Common Equity Tier 1 ratios, while topping up on long-term unsecured debt, all of which will be designed to be easily written down or converted into equity during moments of internal or existential crisis.

But this is where it starts to get fiddly. Some bonds will be disqualified from the new rules, such as Tier 2 bonds with less than five years left to maturity. TLAC also goes way beyond the strictures of Basel III, under which banks will be required to have a minimum total capital ratio of 10.5% in place by 2019 or higher in some jurisdictions.

Under the new rules, G-Sibs will need to have a buffer of between 16% and 20% of the bank’s entire risk-weighted assets in place, comprised mostly of a lender’s loan book.

Me too

No one regulator wants to be at the mercy of another. So it was that just 12 days after TLAC’s introduction, European legislators unveiled their own version. The European Banking Authority’s minimum requirement for own funds and eligible liabilities (MREL) offered the world more than just another unappetising acronym and a new set of financial rules by which to abide.

It was also designed to make credit institutions and large investment firms more resilient, and to ensure they have sufficient loss-absorbing capacity to allow resolution instruments, including the bail-in tool, to be applied more effectively.

The two standards are likely to be different beasts. One divergence will be timing. MREL will be introduced in 2016, though full compliance is likely to be phased in by January 2020. TLAC is unlikely to be imposed fully before 2019, in line with Basel III.

Rules girding both remain ambiguous, and even a little messy. For now, said SG’s Weinberger, “everyone is dealing with the uncertainty by trying to deduce what the regulators might want. Everything will be about timing, implementation, and how financial institutions will adapt their capital-raising programmes to the new laws”.

MREL is destined to be the junior member of the team. It was born later in large part because “no one wanted the two forms of new legislation to be in conflict with one another”, said Robert Montague, a senior investment analyst at ECM Asset Management.

The assumption is that over time, the two will become one, most likely with MREL being absorbed into, and taken over by, its elder sibling. “Whether explicitly or implicitly, it’s assumed that MREL’s standards will migrate upward into TLAC’s,” said SG’s Weinberger.

“You will see a race-to-the-top approach taken by regulators, where they will likely see TLAC as setting a very high bar for too-big-to-fail lenders, and MREL posting a lower bar. So inevitably you’ll see a migration up into TLAC.”

Small but important

There is a logical force of reasoning behind MREL: this isn’t just another power grab by an insecure European regulator desperate for global relevance. Europe is crowded with smaller lenders with little or no wider systemic importance. Yet the London-based EBA recognises that these institutions, ranging from regional Spanish savings banks to veteran Italian lenders, could still undermine their own economies – or the broader European project – during a point of future economic disarray.

Better, or so the thinking goes, to outline rules designed to protect taxpayers against future bank failures while the chance still exists. And while TLAC is a one-size-fits-all slab of rules, every European lender will be handed its own unique set of MREL guidelines.

How much? Of what?

The biggest ongoing challenge for lenders will be to determine how much capital they need to raise, and what form it should take. Neither of these decisions will be simple. Typically, the bigger a bank’s deposit base, the more additional capital it will be forced to raise. HSBC is expected to need around US$50bn to become TLAC-compliant, with Barclays needing US$20bn. Citigroup reckons that European lenders alone will need to raise up to €300bn in additional funding between now and the end of the decade.

The source of the funding is equally tricky, not least because both sets of rules remain so nebulous.

Up to 2.5% of additional TLAC-eligible capital can consist of standard senior debt. That leaves banks needing to raise at least 5.5% (over and above the 8% Basel III capital requirements) to hit their minimum RWA target of 16%. A typical global lender with risk-weighted assets of US$500bn will thus need to raise around US$30bn in extra capital, according to SG estimates.

Some European lenders are already hard at work in the capital markets. In February and March, Deutsche Bank, SG and BNP Paribas issued 10-year Tier 2 subordinated bonds, every cent of which was TLAC-eligible and Basel III-compliant. Credit Agricole raised €3bn-equivalent from its 12-year Tier 2 bullet in March.

The next challenge for lenders will be how to make more of their capital both TLAC and MREL-compatible. So far, European nations have opted for various approaches to the dilemma of how to make more existing or new capital comply with the incoming rules.

A simple solution

Swiss and British banks have opted to issue Tier 2 debt at the holding company level, making it more easily bailed-in. Spanish regulators, unsure how or whether to apply bail-in to retail bonds, are seeking to create a new layer of capital (so-called Tier 3 debt) which would slot in between junior and senior debt.

Jerome Legras, head of research at Paris-based Axiom Alternative Investments, is not alone in believing that a new species of debt instrument would “just complicate matters and turn everything into more of a nightmare”.

The most likely outcome will see Europe align, as is so often the case, to Teutonic logic. In March, Germany’s finance ministry proposed amending the order in which creditors are paid when a bank fails. Senior unsecured bonds would be relegated, becoming subordinate to other senior liabilities, such as derivatives and unsecured deposits, and thus easier to write down in a crisis.

Legras hailed Germany’s plan as “simple and straightforward. It creates a law that completely changes the hierarchy of payments, while making all senior liabilities TLAC-eligible overnight”.

ECM Asset Management’s Montague said the German model “offers a blueprint for everyone. It’s a neat solution to the prevailing problem, particularly for mutual banks that cannot set up holdco structures, and is likely to be adopted elsewhere”.

A simple, sensible, capital markets solution to a potentially migraine-inducing problem, to which all or most European countries are happy to cleave – whatever next?

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